Assured Guaranty Ltd. (AGO) is a high conviction investment for us, which we profiled earlier in the year. On August 9, the company reported 2nd-quarter operating income of $114MM, or $0.61 per diluted share. Year-to-date operating income for the first half of 2012 was $185.2MM, or $0.99 per diluted share. GAAP earnings numbers are rather misleading for bond insurance companies due to the volatility of credit default swaps, which tend to move far beyond the true economic gains or losses the companies are experiencing. Nonetheless net income for the 2nd quarter was $376.5MM, or $2.01 per share. AGO currently trades at $12.83 per share, which is about 50% of the company's book value per share of $24.36. Operating shareholders equity was $28.41, and the adjusted book value was $46.99 at the end of the quarter. These non-GAAP measures reverse the non-economic impacts of mark to market accounting, and in the case of adjusted book value, it also adds the present value of the unearned premium reserve in excess of expected losses to be expensed.
The bond insurance industry is extremely complicated to understand due to the unreliability of traditional accounting metrics. The business is fairly attractive now because just about all of the former leaders in the industry are in de-facto liquidation mode, so profit margins on new business have roughly doubled from 2007 levels. In addition Assured Guaranty has $5.58 billion of unearned premium reserve listed as a liability, meaning that even if the company wasn't able to write new business, AGO could still rely on 3-5 years of solid revenue based on past production. Investors have two ways of winning with AGO:
- The company is downgraded below AA-, meaning the company will have tremendous difficulty maintaining the current business model. This would pressure the company to execute enormously accretive stock buybacks likely causing the stock to double or triple from current prices. AGO would also likely explore other business opportunities such as mortgage insurance, that are less reliant on extraordinary credit ratings.
- The company maintains a AA- or better rating allowing the company to continue writing bond insurance. Little-to-no competition would enable the company to grow shareholder value by 10-15% per annum, and although volume issuance is down due to a confluence of factors, the idea of reducing borrowing costs through bond insurance still makes sense as proven by AGO's recent production. The reduction of uncertainty pertaining to future business opportunities would likely close the discount to intrinsic value currently exhibited in the stock's valuation.
Record low interest rates reduce demand for bond insurance because municipalities are able to obtain low financing costs without the need for Assured Guaranty's higher credit ratings. It also reduces the fee AGO is able to charge for its guaranty, because the fee is usually based on a percentage of the interest savings AGO provides to the bond issuer. In addition Assured Guaranty has been under review for a possible ratings downgrade by Moody's since March, which hurts new business production through the uncertainty that it creates.
Despite these negatives Assured Guaranty insured $4.7 billion in par for the quarter, up 28% YoY, with a present value of new business production of $47MM, up 5% YoY. Just about all of this business was Public Finance as opposed to Structured Finance, which is a tremendous positive from a ratings and capital perspective. In the quarter Assured Guaranty insured 350 new issues proving that demand for bond insurance still exists, even in the most adverse conditions, considering the ratings uncertainty and low interest rates.
AGO specifically targets the Single-A market where the company insured 29% of transactions and 10% of par. Up until this point Assured Guaranty has basically been operating as a monopoly in the industry, with its competition having insufficient ratings to compete for new business. While the overwhelming majority of losses have thus far come from legacy RMBS transactions, recent bankruptcies in Stockton, San Bernardino, Mammoth Lakes, and Jefferson County have some concerned that stretched municipalities will no longer honor debt obligations in the same manner as they have in the past. We believe these concerns are overblown and are more emblematic of incompetent local governments, as opposed to a pervasive mentality spreading across the country. Access to capital markets is essential for just about every local government, and the idea of losing that as opposed to making the generally small percentage of overall expense payments to service debt makes no economic sense whatsoever. Management pointed out that there have been 43 municipal bankruptcies since 1981, and in none of them was principle owed to bond holders cut. For instance in Stockton, California, debt service is only 8% of general fund expenditures, while personnel costs make up 68% of the city's projected expenses. Sometimes it takes the court system through Chapter 9 filings to get governments to act in a responsible manner, but these are risks that a company with the financial strength of Assured Guaranty is able to deal with, just like a P&C insurer is comfortable when a hurricane hits the Gulf of Mexico. Secondly it is just these circumstances when municipalities do withhold payments, that creates the demand for municipal bond insurance, which guarantees the prompt payment of interest and principle on defaulted debt.
In the municipal portfolio of approximately 11,000 exposures AGO is paying claims on only three obligors. Total economic loss development in the quarter was $89.2MM, mostly due to the decline in the risk-free rates used to discount expected losses, which contributed approximately $63MM to the economic loss development in U.S. RMBS, and other long-dated structured finance transactions. Early-stage RMBS delinquencies decreased in all categories except subprime and continued to remain well below January levels in all categories.
After coming to terms in regards to representations and warranties issues with Bank of America Corp (BAC) and Deutsche Bank AG (DB) over the last year, AGO has now reached favorable settlements with respect to approximately 37% of the remaining par outstanding on troubled originations on Assured Guaranty's legacy residential mortgage insured portfolio. Two trial courts have ruled that a breach of loan eligibility justifies the put back whether or not the breach can be proven to a court to have caused the loan default or delinquency. These were notable victories that likely will force some of the banks to settle in regards to their rep and warranty exposure.
Assured has called out Credit Suisse Group AG (CS) and UBS AG (UBS) specifically as two of the banks that seem to be in denial as to their responsibilities on these matters, but AGO isn't under the same liquidity pressures as MBIA Inc. (MBI), therefore it has the ability to wait it out without as much stress. AGO has taken aggressive steps to mitigate risk through purchasing AGO insured bonds in the open market at a discount to par. In the 2nd quarter the company bought a par value of $137MM of bonds at a 40% discount, producing an additional $32MM of economic value. In the 1st-quarter conference call AGO's CFO mentioned that the company had previously bought back $1.7 billion of risk on a par basis for about $800MM, creating $900MM of savings.
This type of capital management is enormously accretive but my greatest gripe with the company is the slow pace of share buybacks. In the quarter AGO bought 2.1 million shares out of its small 5 million repurchase authorization at an average price of $11.76. On June 1, AGO retired $172.5 million of debt that was a component of the equity issued in 2009 to fund the FSA acquisition, and under the terms of the equity units, the debt holders purchased 13.4 million common shares at an average price of $12.85 per share. Ultimately this will result in savings of $14.7MM in annual interest expense, but obviously it is slightly dilutive. There is nothing AGO could do that would be more beneficial than buying back stock at 50% of tangible book value aggressively, and it is my opinion the company is not getting the respect it deserves due to the fact that it isn't taking advantage of its own stock being on sale. I do realize that between the ratings agencies, and the insurance regulators, many constituents are involved with competing interests, but I believe management should be more straightforward about plans of returning capital. Currently AGO offers a dividend yield of about 2.1%, so shareholders get reasonably compensated for waiting for the stock's eventual rise.
Management pointed out that in its June 13, 2012, credit report on Assured, S&P reported that the capital of the operating subsidiaries exceeds S&P's AAA capital adequacy model threshold by $350-$450MM. Since the financial crisis began in 2008, Assured has earned more than $1.8 billion from operations, added $1.8 billion in claims paying resources, which now total $13 billion, reduced insured leverage by 29%, increased the unearned premium reserve by 47% to $5.6 billion and obtained $2.8 billion in recoveries from RMBS warranty providers. Only a group as illogical as the ratings agencies would lower ratings at this stage of the game while having nearly a dozen AAA's going into the financial crisis, that proved to be undercapitalized. White Mountains Insurance Group Ltd. (WTM) recently capitalized a new entrant into the bond insurance industry with $600MM. While additional competition can be a negative, in this case it should provide more legitimacy to an industry, which is recovering from the financial crisis. If this new company is anything like its parent, which is known for disciplined underwriting, winning business by lowering prices to unprofitable levels is not a likely business strategy. If the ratings agencies would just be consistent and state what is required to obtain various ratings, I have no doubt that AGO could achieve a solid AA rating through acquiring reinsurance, reducing exposure, etc. but unfortunately this has not been the case up to this point.
AGO is one of the most volatile stocks to invest in. This is extremely advantageous for value investors that are willing to use a put selling strategy. Currently one can sell the January 14 $13 puts for a staggering $355. This means that assuming the stock closes above $13 in 525 days the profit would be 37.5% or 26% annualized, on the maximum risk of $945. $9.45 would also be the breakeven price and would offer the opportunity to triple one's money potentially. We believe AGO is worth between $30-$40, and if management would pick up the pace dramatically for share buybacks, the upside could be even greater.